Prepare To Short AFC Enterprises

Investors in AFC Enterprises (AFCE) have enjoyed a strong year in which stock price has increased over 75%. This surge in price has added over $400 million in market value to the firm and has propelled the shares to multi-year highs. In this article, I will explore the fundamental drivers which have pushed stock price to these levels and provide a bearish outlook for AFCE.

A History of Returns

In order to fundamentally analyze AFCE, I have relied heavily on return on assets. Return on assets is the net income of the firm divided by average total assets. Examining this ratio is very useful in that it allows us to understand how efficiently an organization uses its assets to generate profits for the firm. In the chart below, 5 years of return on assets can be seen for AFCE.

It can clearly be seen in the chart above that AFCE has experienced a bit of a volatile history in terms of returns. What this fundamentally means is that the firm has oscillated between periods of stronger and weaker performance.

Beginning in 2008, AFCE began a briefly-interrupted period of fundamental decline in which organizational returns fell until the second quarter of 2009. This fundamental decline was in line with the overall recessionary business environment at the time and the stock price fell 33%, along with the overall market.

AFCE began a process of recovery in the second half of 2009 and it continued growing until the first quarter of 2011, as seen by changes in return on assets. This period of growth was marked with a subsequent increase in share price by 82%.

In the second quarter of 2011, AFCE experienced a fundamental contraction in which its firm-level efficiency decreased for the next two quarters. This decrease in firm performance was coupled by an 18% decline in share price.

The fourth quarter of 2011 treated AFCE kindly in that during this period, the organization performed well until the second quarter of 2012. This time of strength was marked with a likewise gain of 60% in the share price.

As you can see, there is a very clear relationship between changes in return on assets and changes in share price. This is a very intuitive fundamental relationship between firm performance and stock performance. As an organization increases its efficiency and grows its ability to transcribe its assets into profits, the market tends to purchase shares in hopes of earning a return. Likewise, as a firm loses its efficiency and experiences contractions, share price tends to fall as well. This simple and logical relationship provides an excellent opportunity for the opportunistic investor. If history and intuition is to be any guide to the future, AFCE is due for a share price contraction in the immediate future. Over the past quarter, organizational efficiency has contracted while the stock has slightly continued its upwards surge. This provides us an opportunity in that the market more than likely will price shares lower in the near future. AFCE has experienced a decrease in fundamental returns and this has historically dictated the direction of stock price in almost every quarter for the past 5 years. I believe that, once again, fundamentals will play out and this security will decline.

Technically Speaking

Even though I am bearish on AFCE, I do not advocate immediately shorting this security. Price has increased 500% over the past 3 years and it is entirely possible that these gains will continue. In order to correctly time entering the market, I believe that investors should wait until price gives a clear signal that the trend has ended. Specifically, I believe a break below $24.50 will signal a strong contraction and investors should consider shorting the security at this point. I believe investors should immediately place a stop at $27.00 in order to preserve capital in the event that this trade is incorrect. Individuals should consider taking profits on half of their position at $21.00. This has been a technically significant barrier in the past and I believe that it could continue to be so in the future. Finally, investors should exit their remaining shares at $17.50. This trade is favorable in that for every $1.00 an investor is willing to risk, he stands to gain $2.10. Mathematically, this means that if this analysis has even a 47% chance of being correct, investors should consider taking the trade. The table and chart below show the breakdown of this recommendation as well as the relevant participation points.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.